Feb 17, 2022
At the start of a new year, it is customary to reflect on the previous year before looking ahead. And upon reflection, 2021 is probably best described as a year where a few of South Africa’s common investment myths were busted. These myths aren’t particular to last year; they’ve been around for a lot longer than that. Here are two myths that have been clouding investor perceptions:
The rand seems to attract many prophets of doom – as we again witnessed at the beginning of 2021. A common myth is that the rand is a ‘one-way bet’ (weaker). This myth was neatly dispelled last year. For most of 2021, the rand outperformed other emerging market currencies. This outperformance was particularly pronounced in the middle of the year when the prices of platinum group metals (PGMs) rocketed, bolstering South Africa’s terms of trade. The rand gave back some of the outperformance in November when the PGM market cooled but was still ahead of its peers over the year, enjoying a positive return. Of course, the volatility of the rand is something investors have to face on a regular basis. Because the rand is a very liquid currency, it can be more volatile than other emerging market (EM) currencies as it is highly traded and serves as a ‘proxy’ for EMs.
The South African government’s fiscal challenges have fuelled the myth that South Africa is a ‘basket case’ and that SA bonds are best avoided. Investors who didn’t buy into this myth, were handsomely rewarded as the All Bond Index (ALBI) returned well over 8% in rands in 2021. But how did our market fare relative to other EMs? Despite difficult conditions for EM bonds, 10-year SA bonds significantly outperformed their EM peers. An improvement in our terms of trade, not only bolstered the rand as mentioned earlier, but also provided much needed revenue to our government. Importantly, National Treasury (NT) demonstrated fiscal restraint. Essentially, it banked most of the mining tax windfall and reduced bond issuance, which helped to support our bond market last year.
While inflation spread rapidly across the globe in 2021, South Africa’s inflation rate was relatively contained. Besides the resilient rand, the South African Reserve Bank’s (SARB’s) measured approach to stimulus helped to keep a lid on inflation. So, myth number two was also firmly busted last year – the strength of the SARB and the relative discipline at NT mean SA government bonds are still an attractive area of the market for investors.
The income environment has changed materially over the last three years, with high real interest rates at the beginning of the period followed by record low interest rates to help stimulate our pandemic-battered economy. Consequently, bonds have become an important source of income for our investors in the Ninety One Diversified Income Fund (the fund).
Against a backdrop of higher global and local inflation, the SARB has embarked on a rate-hiking cycle. Since November last year, we’ve had two interest rate hikes of 25 basis points each, with the repo rate currently at 4%. The SARB has indicated that it will gradually normalise interest rates from their low levels. We expect at least another four rate hikes of 25 basis points each this year. Essentially, the SARB plans to move away from a negative real repo rate over time. The good news for bond investors is that the market is currently pricing in a more aggressive rate-hiking cycle, so the bond market shouldn’t fare badly due to rising cash rates.
Figure 1: Inflation is ticking up… more hikes to come but largely priced in
SA inflation and repo rate outlook
2022 inflation scenarios
Source: Ninety One, data as at February 2022.
Annual consumer price inflation was 5.9% in December, which surprised many market participants (consensus view was 5.7%). The uptick in inflation can largely be attributed to the rising oil price, base effects and higher administrative prices such as electricity. We believe that inflation has peaked and forecast an inflation rate of 5.3% for the year, as shown in the matrix (Figure 1 right-hand side). Oil and the rand remain the biggest risks to inflation, but even if the oil price hovers in the $80-range and the rand is well above R16 to the dollar, we should still see inflation at or around the 5% mark – remaining comfortably within the SARB’s target band.
South Africa’s economy rebounded strongly over the first nine months of last year (GDP growth of 5,8%); however, COVID-related travel bans are expected to have put a dampener on growth in the final quarter. The good news is that we forecast growth to return to pre-pandemic levels at the end of 2022, despite rate hikes. Agriculture, mining and financial services should continue to be key contributors to growth, with the critical manufacturing and construction sectors remaining laggards. Unfortunately, these secondary sectors are a large part of the economy in terms of job creation: electricity constraints, a lack of confidence and policy reform are constraining their growth.
The country’s growth prospects could be materially boosted by beefing up law and order and making more progress on the policy front. A higher growth rate would help to improve the government’s debt situation. As bond investors, we carefully monitor the government’s debt levels. Based on the current growth trajectory, SA’s fiscal debt is forecast to reach 71% of GDP for the 2021/2022 fiscal year. While the picture looks much better than last year thanks to an improvement in our terms of trade and healthier tax revenues, we have experienced a significant deterioration in the debt-to-GDP ratio from pre-pandemic levels. Figure 2 is a useful chart to better understand how growth impacts fiscal debt. We estimate that an economic growth rate of 3% over the next seven years would lower debt to GDP to 61%, while 1% growth over the same period would push it up to 81%.
Figure 2: Fiscal position better than feared but debt won’t stabilise in a low-growth world
Source: Ninety One, January 2022
As mentioned earlier, NT acted responsibly by banking most of last year’s tax windfall, demonstrating a commitment to keep a lid on government debt. Nevertheless, this will likely be a ‘noisy’ year on the political front as the ANC prepares for its elective conference. We will be monitoring the situation to see if the political noise translates into policies that lead to imprudent spending. We support the social measures that are in place and understand the need to extend these to alleviate poverty and hunger. However, we believe these social grants should be funded through public sector wage savings. On balance, the fiscus is better than feared but certainly not out of the woods.
The direction of the rand can largely be seen as a battle between our terms of trade – what we import versus what we export – and capital flows (foreign investment flows into and out of South Africa). Our terms of trade provided strong support for the rand in 2021, thanks to bumper commodity and agricultural exports. But there were also bouts of rand weakness when sentiment turned negative towards EM assets, resulting in foreigners withdrawing capital from our markets.
While our terms of trade should still be supportive for the rand, the global environment poses some risks. Record-high inflation in the US has sparked market worries about the extent of policy tightening. The US Federal Reserve should start raising interest rates as early as March and has already begun winding down its bond-buying programme. The spike in the yields of US Treasuries suggests that the market is pricing in an aggressive rate hiking cycle – with five rate increases priced. This could impact EM markets as global investors gravitate towards dollar-denominated assets. From a portfolio point of view, our foreign currency exposure acts as a risk mitigator during times of rand weakness. We have also used US Treasuries as a hedge in the portfolio to cushion the impact of rising US yields. However, in our view, whilst the best is probably behind us, you can’t be too bearish on the rand, given improving global growth and the favourable outlook for commodity exports.
Despite last year’s outperformance against EM peers, the South African bond market is still offering value. Our government bond yields remain attractive versus EM yields, cash rates and inflation. SA bond investors can earn a yield of around 9.4% on 10-year government bonds, well above inflation.1 In contrast, US Treasury investors have to contend with deeply negative real yields.
Over the past five years, income has been the biggest contribution to SA bond returns, as opposed to capital (Figure 3). Consequently, bonds have been an important source of income for the fund, contributing handsomely to returns. This year should be similar to last year, with income on the table from the bond market. Higher cash rates and wider credit spreads are also contributing to a more favourable income environment. If the government is able to contain its wage bill and we see some concrete progress on the path to structural reforms, SA bonds could enjoy a capital uplift.
Figure 3: All Bond Index returns for the last 5 years
Source: Bloomberg and Ninety One, January 2022.
We have increased our offshore exposure to mitigate some of the local and global risks. The fund has a reasonable allocation to inflation-linked bonds, which helps to protect against any inflation surprises.
The portfolio is marginally underweight credit, with minimal exposure to the cyclical sectors of the economy. We maintain a preference for quality defensives, namely banks, insurers, telecommunications and government-guaranteed debt, as well as large blue-chip corporates with strong balance sheets. As the fundamental picture for listed property has begun to clear, we have increased our allocation. However, we maintain an exposure less than what would have been the case a few years ago as the asset class remains very volatile.
We have a well-diversified portfolio that, when combined with active allocation, is designed to participate in the bond opportunities discussed but also to provide some protection against the multitude of local and global risks. This investment strategy has worked well for us during periods where we have experienced bond market volatility or rand weakness.
1 As at 31.01.2022.